Two safe ways to bottom-fish China

Ivan Martchev is an investment specialist with institutional money manager
Navellier and Associates.
Previously, Ivan served as editorial director at
InvestorPlace Media. Ivan was
editor of Louis Rukeyser's Mutual Funds and associate editor of Personal
Finance. Ivan is also co-author of
The
Silk Road to Riches (Financial Times Press).

I have long believed that investors must be careful stock pickers in the Chinese market and ignore today's teachings that passive index investing is a superior strategy over time — it isn't.

Because of the opaque nature of the Chinese economy — where state-owned enterprises and large, government-controlled banks fund numerous activities on the basis of political directives — economic growth does not produce the earnings growth it would have produced in a properly functioning market.

Busted-bubble markets take time to work out, but the dichotomy between economic growth and shareholder returns is more extreme than even Russia. Developed markets have their problems, too, but most likely would have seen their benchmark stock indices double or even triple had their GDP levels doubled in five years.

What gives?

Trouble in China

Something is amiss in the Chinese economy. One can only hope the incoming Xi Jinping administration will begin more serious reforms.

Chinese companies — the most listed in the U.S. compared to any other major emerging market — have gotten bad press with a series of reports by Muddy Waters Research that have exposed Enron-esque behavior at some of its targets. Even famed billionaire John Paulson got badly burned with a large position in Sino-Forest, which filed for creditor protection in March 2012 after the Toronto Stock Exchange moved to de-list shares for failure to meet listing requirements. In June 2011, Muddy Waters correctly concluded that Sino-Forest grossly exaggerated the value of its plantation assets. Sino's auditor, Ernst & Young LLP, resigned, and the company last noted that it has failed to find a buyer.

Embarrassed by a series of accounting scandals, federal prosecutors have begun proceedings against the separately incorporated subsidiaries of five big accounting firms for failing to turn over evidence. The Chinese claim sovereignty and compliance with Chinese laws; the SEC claims that the investigation of companies whose shares trade in the U.S. demands cooperation.

Chinese stocks have been spotty performers with accounting problems advertised on news channels, yet the Chinese economy delivered 7.4% annualized year-over-year GDP growth in the third quarter. Despite the weak GDP numbers (compared to 2010), between the second quarter and the third, the economy grew at an annualized rate of about 9%. One quarter of annualized growth a turnaround does not make, but it is encouraging.

Remember: Globalization has made the Chinese economy increasingly vulnerable to exogenous shocks, which puts more urgency behind the idea that the next administration must introduce reforms that induce domestic consumption. China still is disproportionately exposed to the U.S. and Europe as export markets.

The latest Chinese data for November show exports grew at a weaker-than-expected 2.9% rate. Export growth had a consensus estimate of 9% and was notably weaker than the 11.6% rise seen in October. China's exports to the U.S. declined 2.6% from a year earlier, while exports to the European Union dropped 18% for a sixth straight monthly decline. I don't know what will happen with the fiscal cliff situation in the U.S., which clearly affects China as a large trade partner, but I am not an optimist on Europe.

The Chinese are between a rock and a hard place. Thus, bottom fishing is only advisable via larger-cap Chinese shares that are undisputed leaders in their industries and can survive any further slowdown should Q3's stabilization turn out to be a false dawn.

Stocks to Consider

BaiduBIDU, -3.64%
shares have been taken down with the selloff in Chinese ADRs. Baidu's primary listing is in the U.S., not in China, though its auditor Ernst & Young Hua Ming LLP still is in trouble for not complying with the SEC. I think Baidu will be the last company to have de-listing risk, as the shares are also part of the Nasdaq-100 Index. They also are followed by many analysts; accounting issues are not as likely as they are with obscure ADRs.

Baidu is growing fast, Chinese slowdown or not. Revenues are forecast to grow 42% next quarter, while its price-to-book (8.1) and price-to-earnings (20.3) multiples have dropped at or below their valuation at the 2009 market bottom. Baidu's shares are priced as if China is experiencing a Lehman moment, which might be a distant possibility, but it's far from likely. Baidu has decimated Google in the mainland market, with 78.6% of China's search-engine market by revenue in the third quarter, compared with 15.4% for Google. There is one small, new Chinese search engine — Qihoo — but it is too small to be a threat.

Another major Chinese company trading at an attractive valuation is energy firm CNOOCCEO, -0.58%
CEO trades at a P/E of 9.6 with an operating margin of 35.28% — I had to pause when I looked at that number. The most profitable major U.S. oil company on an operating-margin basis is Chevron, with the same metric at 15.72%.

With a virtual monopoly on offshore drilling in China — the recent dispute with Japan over uninhabited islands probably is about oil more than anything else — CNOOC seems to have a bright future, especially given that oil demand in China grows faster than the U.S. and the mainland has surpassed the U.S. as the world leader in oil consumption.

Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates holds positionsBaidu, Chevron and CNOOCfor its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the aforementioned securities.Investing in non-U.S. securities including ADRs involves significant risks, such as fluctuation of exchange rates, that may have adverse effects on the value of the security. Securities of some foreign companies may be less liquid and prices more volatile. Information regarding securities of non-U.S. issuers may be limited.

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